90 Cents of Every Pay-for-Performance Dollar are Paid for Luck

Moshe Levy*

Abstract
We empirically estimate that approximately 90% of standard option-based
compensation constitutes pay-for-luck. This value is very robust, and
stems from the inherent fact that chance plays a dominant role in
determining firm performance. The impact of a manager on her expected
compensation via the improvement of firm performance is low, hence, in
contrast to common wisdom, standard option-based compensation does
not constitute a strong motivating force for rational managers. Indexing
and a high strike price can double an options motivational power.
Keywords: executive compensation, pay for performance, pay for luck,
employee stock options, managerial talent, incentives.

JEL Classification: M12, G34.

Jerusalem School of Business, The Hebrew University, Jerusalem 91905, Israel. 972- 2588-1329. mslm@huji.ac.il.

Electronic copy available at: http://ssrn.com/abstract=2837504

I. Introduction
Top executives receive compensation that is astronomical relative to average
salaries. In 2014, the top 200 CEOs in the U.S. received an average compensation of
$22.6 million, which was about 480 times the average salary that year.1 The highest
executive compensation, $156 million, was 3,350 times the average salary. For
perspective, this ratio between the top person and the average person would imply an
individual who is about 3.7 miles tall, or has an IQ of 335,000 points. It is therefore not
surprising that the issue of executive compensation has attracted a great deal of academic
and media attention, and is the focus of an ongoing heated debate. A large part of
executive compensation is pay-for-performance in the form of options and bonuses.
According to Frydman and Saks (2010) and Frydman and Jenter (2010), options
constitute about 30% of total compensation, and bonuses and other long term incentive
plans constitute an additional 20%. This pay-for-performance component of
compensation is the focus of the present study.
On one side of the debate on executive compensation are those who claim that
this compensation is typically only a miniscule part of firm value, and that pay-forperformance effectively motivates managers. If a talented manager increases firm value
by 1%, and receives a compensation that is 0.1% of firm value, this is certainly a good
deal for shareholders. According to this view, high executive compensation is the
equilibrium outcome of a competitive market for rare managerial talent (see, for example,
Rosen 1992, Himmelberg and Hubbard 2000, Oyer 2004, Hubbard 2005, Gabaix and

For a review of top CEO compensation in 2014 see David Gelles, For the Highest-Paid CEOs, the Part
Goes On, New York Times, May 16, 2015. The national average wage index for 2014 is reported to be
$46,481 by the Social Security website.
1

Electronic copy available at: http://ssrn.com/abstract=2837504

Landier 2008, Tervio 2008, Cremers and Grinstein 2014, and Axelson and Bond 2015).2
On the other side of the debate are those who claim that high executive compensation is
not related to economic efficiency, but is rather the result of skimming by managers and
boards that cooperate with them (Newman and Mozes 1999, Bertrand and Mullainathan
2001). Bebchuk and Fried (2009) build a strong and comprehensive case for this view.
While the vast majority of the industry justifies the current option-based compensation
scheme, Warren Buffet presents an exceptional view, stating: There is no question in my
mind that mediocre CEOs are getting incredibly overpaid. And the way its being done is
through stock options (Tully 1998).
A key question in this debate is whether, and to what extent, compensation
represents reward for performance (Hlmstrom 1979). Bertrand and Mullainathan (2001)
elegantly and convincingly show that CEOs are sometimes rewarded for luck. Their
classic example is that of oil company CEOs whose compensations increase with the
price of oil. They have also shown that compensation is sensitive to other observable
factors that are outside the control of the manager, such as exchange rates and industry
shocks. Bertrand and Mullainathan show that boards typically do not adjust for external
chance events and conclude that CEO pay in fact responds as much to a lucky dollar
as to a general dollar (Bertrand and Mullainathan 2001, abstract).
This paper addresses the following two questions: 1) How much of the total
option-based compensation paid out is actually paid for luck? In terms of Bertrand and
Mullainathan, what is the ratio between the number of lucky dollars and general
dollars? and 2) To what extent can the manager increase her expected compensation by
2

Jensen and Murphy (1990) even argue that CEO compensation is too low to motivate managers.

improving firm performance? The answers to these questions are closely related and
depend on the relative importance of talent and chance in determining firm performance.
The following simplified example illustrates this point. Consider a manager who accepts
a project that requires an investment of $4 today, and yields a single cash flow of either
$20 or -$10, with equal probability, one year from now. Assume, for the sake of
simplicity, that the projects cost of capital is 0%. Thus, the projects NPV is $1. When
the project is accepted the firms value increases by $1, and when the uncertain cash flow
is realized, one year later, the firm value either increases by $15 or decreases by $15
(these are the shocks relative to the expected cash flow of $5). Now, suppose that such a
project presents itself and is accepted every year, and that the cash flows of these projects
are i.i.d.. Every year, the firms value will either increase by $16 or decrease by $14 with
equal probability (the $15 shock of the realized cash flow, plus the $1 NPV of the new
project accepted). An at-the-money Call option on the firms stock granted at the
beginning of the year and exercised at the end of the year will be worth at maturity either
$16 or $0 with equal probability. Now consider a second manager who is untalented. This
manager accepts identical projects, but with a required investment of $6, and hence an
NPV of -$1. This second managers firm value will change by either $14 or -$16 every
year (the $15 shock of the realized cash flow, plus the -$1 NPV of the new project
accepted), and his option will be worth either $14 or $0 at maturity. Thus, the expected
compensation of the first manager who is talented and increases firm value, and the
second manager, who is untalented and destroys firm value, are almost the same. This
implies that most of the compensation in this example is paid for luck rather than talent.
Furthermore, if the talented manager is required to exert effort in order to employ her

project-selection talent, her motivation to do so is small. Obviously, the conclusions

depend on the numbers employed, and will be reversed if the projects NPVs are much
larger relative to the cashflow volatility. However, as will become evident in the
empirical part of the paper, the ratio of 1:15 between the NPV and cashflow standard
deviation that is employed in the example is actually quite realistic: the standard
deviation of annual returns is typically about 30%, and a manager who increases her
firms average return by 2% should be considered very talented.
The NPV of the projects selected by the manager (or alternatively, the stocks
average return) is a measure of the managers talent. The volatility of the cash flows (or
alternatively, the volatility of the stock returns) is a measure of the role of chance in
determining firm value. The ratio between these two values determines both how much of
compensation represents pay-for-luck, and the influence that the manager has on her
expected compensation via firm performance. The higher this signal-to-noise ratio, the
larger the proportion of compensation that is pay-for-talent, and the larger the managers
motivation to exert effort. This is the basic intuition of the paper.
In the next section we formalize this intuition in a model where returns and
managerial talent are distributed normally. We show that the proportion of option-based
compensation that is pay-for-luck across all managers depends only on the signal-tonoise the ratio T / R , where T is the standard deviation of managerial talent, and

R is the standard deviation of stock returns. We derive the relationship between

T / R and the proportion of pay that is pay-for-luck, and show that this proportion
approaches 100% very quickly as the signal-to-noise ratio deteriorates. In Section III we

discuss various empirical estimates of T that appear in the literature, and provide
empirical estimates for R . These estimates imply that approximately 90% of
compensation is pay for luck.
The degree to which a manager can increase her expected compensation by
exerting effort to manifest her talent is inversely related to the pay-for-luck component.
This is discussed in Section IV. A 90% pay-for-luck component implies that the manager
can increase her expected compensation by only 11% by exerting effort. This is a rather
bleak picture regarding the options power to incentivize managers. In Section V we
quantify the degree to which indexing and granting premium options which are out-ofthe-money increase the options motivational force. Section VI concludes with a
discussion of the implications.
II. The Proportion of Option-Based Compensation that is Pay-for-Luck
We model the impact of a manager on her firms performance by assuming that a
manager who exerts effort and manifests her talent increase the firms expected return by
the magnitude of her talent. We denote the managers talent by T, and the rate of return
on the stock of the managers firm in excess of the market (or industry) return by R. R is
assumed to be distributed normally with mean T and standard deviation R . The
manager is granted an at-the-money Call option on the firms stock.3 We initially assume
that the option is indexed to the market (or industry). This assumption yields a lower
bound on the pay-for-luck component, because the typical options that are not indexed

The number of options granted is irrelevant to the issue at hand, as this number multiplies both the total
option-based compensation and the part of the compensation that is pay-for-luck, and therefore does not
change the proportion of the total compensation that is pay-for-luck.

are more loosely linked to the managers talent, and thus involve a higher pay-for-luck
component. The effects of indexing and granting out-of-the-money options are discussed
in Section V. For the indexed at-the-money option, the managers compensation is R if
R>0, and 0 otherwise. The manager should be compensated for her talent, T. Thus, any
compensation beyond T represents pay-for-luck. There are three possible cases in which
compensation is paid:
i)

R>T>0 :

the compensation R can be decomposed into two components:

compensation for talent, T, and compensation for luck, R-T.

ii)

T>R>0 : the entire compensation is due to talent, and in fact, the manager is
under-compensated in this case.

iii)

R>0>T : the entire compensation is due to luck.

The expected total option-based compensation for a manager with talent T is given by:

1
2 R

R T 2

2 R2

RdR .

(1)

The part of the compensation that represents pay-for-luck depends on whether T is

positive or negative. For the untalented manager with T<0, the entire compensation is due
to luck. For a manager with positive talent, T>0, the expected pay-for-luck compensation
is:

1
2 R

RT 2
2 R2

R T dR

1
2 R

z2
2 R2

zdz

R
.
2

(2)

Note that the integration is only over cases where R>T, as in the cases where R<T the
pay-for-luck component is 0. Also, note that in this case of T>0, R>T automatically also
implies R>0.
For a manager with positive talent, the proportion of compensation that is due to
luck is given by pay-for-luck component (2) divided by the total compensation (1):

R
2

1
2 R

R T 2
2 R2

RdR

R2

R T 2
2 R2

RdR.

(3)

Note that this pay-for-luck proportion depends only on the ratio

R
T

: if both R and T

are multiplied by some positive constant a, the pay-for-luck proportion remains

unchanged:

a 2 R2

(4)
R aT 2
2 a 2 R2

RdR

a 2 R2

aR* aT 2
2 a 2 R2

a 2 R * dR* R2

R* T 2
2 R2

R * dR*

where the change of variables R aR is employed.

*

Figure 1 shows the proportion of compensation that is pay-for-luck for a manager

with positive talent (given by eq.(3)) as a function of

R
T

. Note that for

R
T

1 pay-for-

luck is only about 20% of compensation. However, pay-for-luck grows very quickly, and
for

R
T

2 it is about 50%. For

R
T

10 pay-for-luck is about 90%.

(Please insert Figure 1 about here)

Equations (1-3) relate to a single manager with talent T. In order to obtain

aggregate market-wide results, we assume that talent is normally distributed across
managers with mean 0 and standard deviation T .4 Aggregating (1) across all managers,
the expected total compensation (ETC) is:

ETC

1
2 T R

T 2
2 T2

The expected pay-for-luck is

1
2 R

dT e

RT 2
2 R2

RdR .

(5)

R
for managers with positive talent (eq.2), and is
2

R T 2
2 R2

RdR for managers with negative talent (i.e. the entire compensation is

due to luck in this case). The aggregate expected pay-for-luck (EPFL) compensation is
obtained by integrating over all managers, and is thus given by:

EPFL

1
2 T

1 R

2 2

T 2
2 T2

dT R
2
1

2 T R

T 2
2 T2

1
2 T R

dT e

T 2
2 T2

R T 2

2 R2

dT e
0

R T 2
2 R2

RdR
(6)

RdR.

The expected proportion of aggregate compensation that represents pay-for-luck is

EPFL / ETC .
Proposition 1: EPFL / ETC depends only on the ratio

R
.
T

The mean excess return of a manager with talent T is T. Thus, an average value of 0 for T across all
managers implies that the average excess return is 0.

Proof: If both R and T are multiplied by the same positive factor a, then both ETC
and EPFL are also multiplied by the same factor a, hence the ratio EPFL / ETC remains
unchanged. For more details, see the appendix.
Figure 2 shows the proportion of aggregate compensation that represents pay-forluck, EPFL / ETC as a function of the ratio

R
(the inverse of the signal-to-noise
T

ratio). It is obtained by numerically evaluating eqs.(5) and (6). Note that for values of

3 the proportion of compensation that is pay-for-luck exceeds 80%. For R 6 it

T
T
exceeds 90%. In the next section we discuss the empirical estimates of R and T , and
show that the empirical estimates of

R
typically exceed 6.
T

(Please insert Figure 2 about here)

III. Empirical Estimates of Talent and Noise

Evaluating the proportion of option-based compensation that is pay-for-luck
requires an empirical estimate of the ratio

R
. This section provides an empirical
T

estimate of R for various possible specifications of the return employed (subsection A),
and reviews estimates of T that are available in the literature (subsection B). While the
empirical methods and estimates of T vary considerably, we should stress at the outset
that our conclusions about the magnitude of pay-for-luck are not sensitive to the exact

value of

R
. As Figure 2 shows, pay-for-luck constitutes over 90% of the compensation
T

for any value of

R
greater than 6. The empirical estimates exceed this value, regardless
T

of the method employed to estimate T .

IIIA. Estimating R
R is the stocks return in excess of the market or the industry, or the residual after
the stock return is regressed on both the market and the industry, depending on how the
indexation is defined. Table I reports R for all of these specifications. We employ
annual returns from the CRSP database over the 1996-2015 20-year period. The table
reports results for S&P 500 stocks, as well as for all stocks in the database with complete
return records over the sample period. The S&P 500 index is taken as the market, and the
Fama-French 48 industry portfolio returns are employed as industry returns.
As expected, R is lower for the S&P 500 stocks than for all stocks. Also, the
industry provides a better adjustment (i.e. a lower R ) than the market as a whole, and
the best adjustment is obtained by regressing the return on both the market and the
industry. With this best adjustment the average value of R for S&P 500 stocks is about
30%.

(Please insert Table I about here)

10

IIIB. Estimating T
The estimation of managerial talent is a difficult task. There are three different
approaches in the literature, employing different methodologies. The estimates obtained
with these different approaches vary considerably. Luckily, our results are not very
sensitive to the exact value of T . The important point, from the perspective of the
present paper, is that in all of the approaches employed the estimate of T is much lower
than the typical value of R .
One approach for evaluating managerial talent is the manager fixed-effect
approach, employed most notably by Bertrand and Schoar (2003). When they take ROA
as the dependent variable, they find that the manager at the 75th percentile of the
distribution increases the ROA by about 3%, and the manager at the 25th percentile of the
distribution decreases the ROA by about 3%. For a normal talent distribution, this implies

T of about 4.4%.5 We should note that this estimate may be upward biased, because
some of the measured effect may be spurious. For example, suppose that managers all
draw ROAs from the same distribution. Then the lucky managers will have a large
positive manager fixed-effect, and a large average ROA, and the opposite will hold for
unlucky managers. In other words, some of the measured difference in talent may
actually be due to luck.
The second approach for evaluating talent measures the stock return when the
manager is replaced. Hayes and Schaefer (1999) document an average price reaction of

The 75th percentile is 0.674 standard deviations to the right of the mean, i.e. 3% 0.674 T ,

T 4.4%.

11

or

-1.5% when managers are hired away by another firm. Bennedsen, Perez-Gonzalez, and
Wolfenzon (2008) find that when the CEO dies firm profitability decreases by 0.77% on
average. These estimates measure the lifelong effect of the manager on the firm. Thus, in
terms of the effect of the manager on the firms annual return, the values are roughly an
order of magnitude smaller, i.e. in the order of 0.1%.
A third approach analyzes the joint distribution of firm size and CEO
compensation, and employs a matching model to derive the differences in managerial
ability (Tervio 2008, Gabaix and Landier 2008). Both of these papers conclude that the
differences in CEO talent must be extremely small. Gabaix and Landier estimate that if
the best CEO were to replace the CEO ranked 250, the value of the firm (of the replaced
CEO) will increase by only 0.016%. Intuitively, if CEOs had more of an impact on firm
value, the compensation of CEOs in large firms should have been even much larger than
they actually are.
The different estimates of T thus range from nearly zero up to 4.4%. We will
employ the middle point of T 2.2% . We should stress that the estimate of the payfor-luck component is not very sensitive to the exact values of T and

R , as revealed

in Figure 2.
The values of values of

R and T discussed above are annual. The time period

executive options are held until they are exercised is typically about 4 years (see Aboody
et. al. 2008). For this horizon the relevant value of R is 30% 4 60% , and the

12

relevant value of T is 2.2% 4 8.8% .6 Hence, we obtain a ratio of

R 60

6.82
T 8.8

. As Figure 2 reveals, for this value the proportion of pay that is pay-for-luck exceeds
90%. Note that this result is quite robust: for any value of

R
greater than 3, the pay-forT

luck component exceeds 80%.

IV. Option-Based Compensation as a Motivating Force
The finding that a very large part of option-based compensation represents payfor-luck suggests that this compensation is not likely to be a very effective motivating
force for the manager. Indeed, the options motivating force is closely linked to the
proportion of pay that represents pay-for-luck.
Consider a manager with positive talent T, who is required to exert some effort
(which is not easily observable) in order to employ his talent. By how much will this
increase her expected compensation? If the manager exerts effort, and her talent becomes
manifested, the firms return is, as before, assumed to be normally distributed with mean
T and standard deviation R . The manager may also choose not to exert effort, in which
case her talent is not manifested, and the expected excess return is 0 (the standard
deviation is again R ). By how much does exerting effort increase the managers
expected compensation?
If the manager does not exert effort, her expected option-based compensation is:

We ignore compounding effects, which are of no material consequence for the present discussion.

13

ECnoE

e
2 R 0

R2
2 R2

RdR

R
.
2

(7)

If the manager with talent T exerts effort, her expected compensation is:

ECE

1
2 R

R T 2

2 R2

RdR

(8)

The increase in the expected compensation induced by manifesting talent T, relative to

the case of no effort, is EC E EC noE 1 .
Note that the incentive power of an option is usually measured by the the options
delta, i.e. the increase in compensation driven by a $1 increase in the stock price (see, for
example, Johnson and Tian 2000). This increase in stock price may or may not be driven
by the actions of the manager. The measure we suggest above is directly tied to the
managers actions and talent: by exerting effort and manifesting her talent, the talented
manager shifts the return distribution to the right, hence increasing her expected
compensation. The measure

EC E

EC noE 1 indicates the relative increase in

compensation due to the managers talent.

The ratio

ECE ECnoE

R T 2

1
2 R2

e
RdR

2 R 0

R
e
2 0

R T 2
2 R2

RdR R2

(9)

is exactly the inverse of the pay-for-luck component of the manager see eq.(3). Thus, if
a typical managers pay-for-luck component is 90% of her total compensation, this means
14

that by exerting effort and manifesting her talent the manager increases her expected
compensation relative to the case of no effort by EC E ECnoE 1 1 0.9 1 0.11 , i.e.
by 11%.
Does this constitute a strong motivating force for the manager? This is somewhat
doubtful. An increase of 11% in expected compensation does not seem a very strong
motivation, especially when the baseline expected compensation is high even with no
effort. It seems likely that other factors, such as ego, self-fulfillment, and the desire not to
be perceived as lazy, are likely much more effective motivating forces.
The empirical evidence regarding the effect of option grants on the future
performance of the firm is mixed.7 This may be due to the fact that most firms grant
options on a regular basis, which makes it difficult to infer a casual relation (Larcker,
2003). Aboody, Johnson, and Kasznik (2010) circumvent this problem by looking at
option repricing following a large drop in stock price. They find that after they control
for various firm characteristics that explain the decision to reprice, the repricing has no
explanatory power of future performance. This finding is consistent with our analysis
suggesting that standard options constitute a low motivating power for the manager.
V. The Effects of Premium Options and Indexation
The analytical results of the preceding sections are for at-the-money options that
are indexed to the market (or industry, or both). These results constitute a lower bound on
the pay-for-luck component, and thus an upper bound on the motivational force of the
option, relative to the typically employed standard non-indexed at-the-money options. In
7

See, for example, Hanlon et. al. (2003), Ittner et al. (2003), Larcker (2003), and Hillegeist and Penalva
(2004).

15

order to quantitatively analyze the effects of indexation and exercise prices that are above
the granting-day price we employ the following numerical analysis. As before, the
average excess return is assumed to be the managers talent, T. We take:
~
~
r Rm T ~ ,

(10)

~
r is the firms return, Rm is the market (or industry) return, and ~ is random noise
where ~
with mean 0.8 For a standard non-indexed at-the-money option the payoff is r whenever
r 0 , and 0 otherwise. For an indexed at-the-money option the payoff is r Rm

whenever r Rm , and 0 otherwise. For a non-indexed premium option with a strike price
set at p% above the granting-date price the payoff is r p whenever r p , and 0
otherwise. For an indexed premium option with a strike price set at p% above the
granting-date price the payoff is r Rm p whenever r Rm p , and 0 otherwise.
For each of these options we measure the managers incentive as the relative
increase in her expected compensation when she exerts effort and manifests her talent, T,
~
relative to the case with no talent, i.e. the case where T=0 and ~
r Rm ~ . We estimate

this incentive for an option exercised in 4 years, which is close to the typical holding
period of employee stock options (see Aboody et. al. 2008). Rm and m are taken as the
empirical mean and standard deviation of the S&P500 annual returns during 1996-2015,
which are 9.93% and 18.75%, respectively. R ( ) is taken as the empirical estimate
of 30% (see Table I). The expected compensation is calculated by numerically simulating
1,000,000 4-year periods.
8

~
~
~
r Rm T ~ , i.e. R .
R , the return in excess of the market is thus R ~

16

Figure 3 shows the increase in the expected compensation as a function of the

talent, T, for at-the-money options (Panel A), premium options with a strike price 50%
higher than the grant-day price (Panel B), and premium options with a strike price 100%
higher than the grant-day price (Panel C). In all three cases the results are shown with and
without indexing (thin and bold lines, respectively). As expected, indexing always
increases the options motivational force. For example, for a manager with talent T=2%
the increase in expected compensation relative to the no-talent case is 12% without
indexing, compared to 16% with indexing (see Panel A of Figure 3). In itself, indexing
does not have a very dramatic effect. However, combined with setting the strike price
50% higher than the grant-day price, the joint effect can be substantial. For an indexed
option with such a strike price the expected compensation is 20% higher relative to the
case of no talent, i.e. no effort, (see Panel B). Hence, indexing the option and setting a
high strike price can almost double its motivational power from the point of view of the
manager (20%, compared with the 12% increase in expected compensation in the case of
the standard non-indexed at-the-money option).
(Please insert Figure 3 about here)

VI. Conclusions
It is well-known that some part of performance-based compensation is actually
pay-for-luck. The contribution of this paper is to show that this part is in the ballpark of
90%. This result stems from the fact that the variability of a firms returns is typically
much larger than the impact of the manager on the average return. More fundamentally,
17

the volatility of a typical projects cash flows is much larger than the projects NPV.
Therefore, adjusting compensation to the market or industry returns has only a rather
small influence on the proportion of pay that is pay-for-luck. Similarly, employing
accounting variables, such as cash flows or income, instead of returns, is not expected to
alleviate the problem.
It is hard to accept the fact that chance plays such a dominant role in determining
firm performance. Many examples of charismatic CEOs and wise strategic decisions that
have lead firms to prosperity come to mind. However, can we really determine what part
of success is due to the manager, and what part is due to chance? A managerial decision
that is followed by a positive outcome may be labeled in retrospect as a good decision,
when in fact, the outcome was just a lucky realization (however, the role of chance is
usually fully acknowledged by management when a bad outcome is realized).
The empirical evidence suggests that chance plays a very big role in determining
performance. This idea was captured many years ago in a passage attributed to King
Solomon:
I returned and saw under the sun, that the race is not to the swift, nor the battle to
the strong, neither yet bread to the wise, nor yet riches to men of understanding, nor
yet favor to men of skill, but time and chance happeneth to them all.
Ecclesiastes 9:11
Some managers are certainly talented, and this talent may be extremely valuable
for firms. However, the evidence suggests that because of the very low signal-to-noise
ratio, reliably detecting and rewarding this talent is practically very difficult.

18

Option-based compensation is widely perceived as an effective motivating force.

However, given that most of it is pay-for-luck, this perception is not well-grounded. A
very talented manager who is required to exert effort in order to manifest her talent,
typically increases her expected option-based compensation by only about 10% by doing
so. This does not seem like a very strong motivating force. It is likely that other factors,
such as ego, the desire for self-fulfillment, and the fear of termination, are much stronger
motivating factors. This is consistent with the empirical findings of Aboody, Johnson,
and Kasznik (2010).
Option-based compensation is often perceived as a good way to align the
incentives of risk-averse managers with those of risk-neutral stockholders.9 Clearly,
options increase the managers appetite for risky projects. But they may cause incentive
alignment problems that may be larger than those they are designed to solve. The
evidence regarding managerial talent suggest that it is much easier for the manager to
increase risk than it is to make sure that this risk is accompanied with proper
compensation in terms of return. The manager may view projects with volatile cashflows
and negative NPVs as desirable even if the manager holds equity in the firm, as long as
the positive effect of these projects on her expected compensation are larger than their
negative effect on her equity.
Some argue that high CEO compensation is an efficient way to motivate
employees competing for the position of CEO in a tournament setting.10 This is a
powerful argument in favor of high compensation. However, it is not clear why this

For instance, see Pukthuanthong, Roll, and Walker (2007).

See, for example, Kale, Reis, and Venkateswaran (2009).

10

19

compensation should be disguised as pay-for-performance when it is almost entirely payfor-luck, unless this is the only way to approve compensation levels that stockholders
would have otherwise objected to.
Our findings support the view that managerial compensation is driven to a large
extent by skimming, rather than being the result of an efficient competitive market for
managerial talent. Options may very well be a necessary, albeit a very far from perfect,
component of managerial compensation. However, as Bebchuk and Fried (2009)
forcefully argue, it is hard to justify the fact the vast majority of employee options are
non-indexed and granted at-the-money: indexing options to the market or industry and
setting the strike price much higher than the granting-day price typically doubles the
options motivational force for the manager. This is a point that boards and investors
should carefully consider.

20

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Table I
The standard deviation of stock returns, R , for various specifications. Annual returns over
the 1996-2015 20-year period from the CRSP database are employed. The S&P 500 index
returns are taken as the market return, and the Fama-French 48 industries are used. The right
column shows the results for all stocks with complete return records over the sample period.

S&P 500 Stocks

All Stocks

mean:

40.9%

52.2%

median:

33.9%

40.8%

mean:

38.4%

50.3%

median:

30.5%

39.6%

mean:

34.5%

47.9%

median:

27.1%

37.9%

mean:

29.9%

42.7%

median:

23.3%

33.0%

Raw returns

Excess of the market

Excess of the industry

Residual after regressing

on both the market and
the industry

Figure 1
The proportion of compensation that is pay-for-luck, as a function of

, as given
T
by eq.(3). T is the managers talent, and R is the standard deviation of the stocks
excess returns.

Figure 2
The proportion of aggregate compensation that is pay-for-luck, for a normal
distribution of talent, as a function of

R
, as given by eqs.(5-6). R is the standard
T

deviation of the stocks excess returns, and T is the standard deviation of talent
across managers.

Figure 3
The increase in the expected compensation relative to the case of no talent, as a
function of the managers talent, T. A manager with talent T=2% who exerts effort
and manifests her talent increases her expected compensation by only 12% if she is
granted standard non-indexed at-the-money options (Panel A, bold line). If the
option is at-the-money but indexed, this value increases to 16% (Panel A, thin line).
If the option is indexed, and the strike price is 50% higher than the grant-day price,
the increase in expected compensation induced by manifesting talent is 20% (Panel
B, thin line). Further increasing the strike price to 100% higher than the grant-day
price further increases the options motivational force, but not dramatically so (Panel
C).

Appendix
Let us denote the new values of ETC and EPFL after R and T are multiplied by the
factor a by ETC* and EPFL*. We have:

ETC *

T 2

2a T a R

2 a 2 T2

R T 2

dT e

2 a 2 R2

RdR .

By change of variables T aT * and R aR* we have:

2

ETC *

1
2a T R
2

a 2T *

2 2

2a T R
2

T *

2 T2

a 2 R* T *

2a
*
e T adT e

2 a 2 R2

a 2 R * dR*

R* T * 2

dT * e

2 R2

R * dR* a ETC .

Similarly, EPFL* a EPFL :

1 a R
EPFL*
2 2

T 2

1
2a 2 T R

2 a 2 T2

1 a R
2 2

1
2a T R
2

R T 2

dT e

a T

2a
*
e T adT e

2 a 2 R2

RdR

0
2 *2

2 2

a 2 R* T *
2 a 2 R2

2
a 2 R * dR*

a EPFL

Q.E.D.
Thus, multiplying both R and T by some positive constant a does not change the ratio
EPFL/ETC. Hence, EPFL/ETC is a function only of the ratio R / T .